WHY ACCOUNTING RESULTS ARE GARBAGE

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WHAT ACCOUNTANTS DO NOT TELL YOU

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economists and other social scientists have rightly pointed out that the accounting system does not always give correct information for decision making - at least that the information is not always complete. in certain circumstances the difference can be big

in this post I will present two 'silent' assumptions inherent in normal accounting as well as some examples of things that are not captured in common accounting

the first assumption in accounting for a business is that the business is a 'going concern', that is the business will continue doing business as is. this is not always the case. a business may go bankrupt, part of the business may be sold, there may be big technological change, there may be new products and so on. in terms of financial risk such situations can have unexpected effects because of too high asset valuations. just to illustrate, think of an expensive purpose built machine for a particular product for which there is no more demand - and this machine would only have scrap value. of course accountants and auditors are well aware of the 'going concern' assumption and always on the lookout for possible adjustments - but by nature other managers in a business or industry analysts may have this information earlier

a second assumption is that the value of money (the accounting unit like USD or EUR) remains the same, in other words that the goods and services involved in a business continue to be bought and sold for the same prices and have the same market value. this is not always the case and maybe it is better to say it is always not the case. think of inflation (even hyperinflation, or deflation), commodity price changes, exchange rate fluctuations, wage increases, or regulatory changes making things more expensive for example. economists have developed a nice theoretical concept called 'replacement value accounting' to take care of this. it involves continually accounting for everything at current prices and market values. this is different from normal accounting at historic prices and theoretically correct. to illustrate, just think of hyperinflation - in such a situation normal accounting will show big profits while in reality the profits may not be big enough to keep the business going

OK, we are tearing up the accounting universe here. some examples now of other things that are not or differently captured in the accounting system:
  • research and development costs are usually taken as expense when incurred (conservative approach) when in fact they may represent an increase in value of the business
  • human resources are accounted for as costs, not always fitting for the people that make the business work

there are many instances where the accounting for a business may not reflect economic reality. in my opinion this does not change anything in terms of the accounting system acting as the cornerstone for the financial management of a business. the accounting system does what it does and it is good at doing that. there are things that the accounting system does not do and these must be captured by other means in business controlling and financial management. in doing so it is best to leave the accounting system untouched (not try and adapt it), otherwise the risk is that the system will become complicated, unreliable and can no longer perform its basic function

it is really not so bad that the accounting system does not tell you everything, as long as you know



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